The
Covered Short Strangle is another risky income strategy, though it is certainly
an improvement on the Covered Short Straddle. The concept is to increase the yield
of the Covered Call by selling an out-of-the-money (lower strike) put. In this
way we take in the additional income from the sold put; however, if the stock
price falls below the put strike, there is a significant price to pay in terms
of risk.

The
sold put adds significant extra risk to the trade. The amount of potential risk
added is the put strike less the put premium received. Say if we trade a
Covered Call on a $24.00 stock, taking in $1.00 for the $25 strike call, our
risk and break even is $23.00. If we sold a $22.50 strike put for another
$1.00, our initial yield on cash would be doubled. . . but our risk would have
increased by another $21.50 ($22.50 minus $1.00), making our total risk $44.50
if the stock falls to zero.

Although
this is unlikely to occur in just one month, the position can become
loss-making at approximately double the speed as a simple Covered Call
position, so if the stock starts to fall, we can be in trouble much more
quickly.

If
the stock falls below the put strike at expiration, the call will expire
worthless (so we keep the premium), the put will be exercised, and we will have
to buy more stock at the put strike price. With a falling stock, this can be
pricey and undesirable. If the stock is above the call strike at expiration,
then we are happy because our sold put expires worthless, our sold call is
exercised, and we simply deliver the stock we already own.

P/L
Profile

When To Use

If you have enough cash to fulfill
the exercise you may have on the downside, and you are confidently bullish and
want to accrue income.

Example

XXXX is trading at $28.20 on
February 25, 2011.

Buy XXXX at $28.20.

Sell the March 2011 30 strike put
for $2.60.

Sell the March 2011 30 strike call
for $0.90

Benefit

The ability to increase the yield
of a covered call.

Risk vs. Reward

The risk is that if the stock
falls, the calls will expire worthless and you will have to buy more stock.
However, the reward, if the strategy is executed well, is increased yield.

Net Upside

Premium received for the calls and
puts plus the strike price minus the purchase price of the stock.

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